Look Out for Nat Gas ETN Premium

NEW YORK ( TheStreet) -- Natural gas prices have seen some glimmers of life during the opening weeks of 2012, leading investors and analysts to question whether the battered fuel's multi-year descent is at last coming to an end.

Despite this improving sentiment, I believe conservative minded investors should continue to steer clear.

As I explained at the end of January , the battered fuel source has become an increasingly popular destination as speculative traders attempt to call a bottom.

The government is doing little to restrain interest, either. In his State of the Union Address, President Obama laid out his "all-of-the-above" energy plan, in which he looked favorably upon our substantial shale gas reserves. He also noted that the hydraulic fracking industry has the capability to create hundreds of thousands jobs over the next decade.

From an investment perspective, this type of surging interest is not necessarily a good thing. On the contrary, we are currently witnessing one popular natural gas ETN get too big for its britches.

As droves of investors and traders have sought out ways to position themselves to benefit from a potential natural gas turnaround, the iPath Dow Jones UBS Natural Gas Subindex Total Return ETN ( GAZ) has become increasingly disconnected from its underlying index. According to Morningstar, the fund boasted a substantial premium that stood at nearly 15.5% last Friday.

Premiums occur when a fund is no longer able to create the shares needed to satisfy demand, ultimately capping the fund's growth. In essence, GAZ has begun to trade like a closed-end fund.

In the past, we have watched the managers of funds like GAZ and the United States Natural Gas Fund ( UNG) halt share creation in order to avoid bumping against limits set by regulators like the Commodities Futures Trading Commission.

In early 2011, for example, GAZ ran into the same trouble when natural gas fell into favor following the devastating Fukushima nuclear crisis. Investors piled into the fund, pushing its premium to nearly 18%.

Funds have also been interfered with for political and economic reasons as well. Last year, as Egyptian protestors took to the streets, the nation's markets were closed. In response, Van Eck announced that it was halting share creation in the Market Vectors Egypt ETF ( EGPT) until the markets were reopened. During this time, investors piled into EGPT resulting in the development of a massive premium.

Premiums can magnify a fund's action in either direction, making it difficult for investors to predict where it will head next. The impact could be seen recently when comparing the recent performance of GAZ to UNG. Both are designed to track the performance of natural gas futures contracts. On Friday, however, GAZ jumped over 2% while UNG, which currently boasts no premium, fell 1.5%.

In the event that GAZ's creation/redemption mechanism is eventually restored to normal, investors can expect GAZ to quickly realign with its underlying index. For investors left holding onto the ETN, such a move would likely prove gut-wrenching.

While interesting to watch, GAZ is not a fund I would encourage any long-term minded investor to try their luck with at this time.

Written by Don Dion in Williamstown, Mass.


At the time of publication, Dion Money Management did not own any equities mentioned.